By Warren Mosler, an investment manager and creator of the mortgage swap and the current Eurofutures swap contract and Philip Pilkington, a journalist and writer based in Dublin, Ireland
The Eurozone has certainly seen better days. The mess – to paraphrase a dodgy Irish politician – is only getting messier.
This is all avoidable, of course, and if the European authorities decided to take action and have the ECB backstop the sovereign debt of the periphery the whole crisis would come to an end. But the European authorities, for a variety of reasons, do not seem to want to do this. And even if they did there would be the issue of austerity: would they continue to force ridiculous austerity programs down the throats of the periphery governments? And if so, then for how long? Leaked documents from within the Troika show the austerity programs to be an abject failure and yet European officials continue to consider them the only game in town. So, we can only conclude at this stage that, given that European officials know that austerity programs do not work, they are pursuing them for political rather than economic reasons.
So, we contend that the periphery governments should have a credible exit strategy on hand and it is to this that we now turn.
Such a strategy would not be very hard to implement and would consist of two key principles:
1. Upon announcing that the country is leaving the Eurozone, the government of that country would announce that it would be making payments – to government employees etc. – exclusively in the new currency. Thus the government would stop using the euro as a means of payment.
2. The government would also announce that it would only accept payments of tax in this new currency. This would ensure that the currency was valuable and, at least for a while, in very short supply.
And that is pretty much it. The government spends to provision itself and thereby injects the new currency into the economy while their new taxation policy ensures that it is sought after by economic agents and, thus, valuable. Government spending is thus the spigot through which the government injects the new currency into the economy and taxation is the drain that ensures citizens seek out the new currency.
The idea here is to take a ‘hands off’ approach. Should the government of a given country announce an exit from the Eurozone and then freeze bank accounts and force conversion there would be chaos. The citizens of the country would run on the banks and desperately try to hold as many euro cash notes as possible in anticipation that they would be more valuable than the new currency.
Under the above plan, however, citizens’ bank accounts would be left alone. It would be up to them to convert their euros into the new currency at a floating exchange rate set by the market. They would, of course, have to seek out the currency any time they have to pay taxes and so would sell goods and services denominated in the new currency. This ‘monetises’ the economy in the new currency while at the same time helping to establish the market value of said currency.
That the new currency should have a floating exchange rate is absolutely key. Some commentators have suggested that upon exit the country in question pegs the new currency to the euro to ensure that it retains its value. In this scenario the new currency would then retain its value vis-à-vis the euro. Thus import prices would not go up unless the government made a conscious decision to devalue the currency.
This might sound good on paper, but we contend that it would be nothing less than an ‘out of the frying pan, into the fire’ scenario were it ever applied in reality. In order to peg the new currency to the euro, the central bank would have to hold adequate amounts of euros in reserve. By pegging their new currency to the euro they would essentially be making the promise that they would swap euros for the new currency on demand. And so they would have to somehow obtain and hold adequate reserves of euros to do so. In this case we assume that this would mean an accumulation of debt denominated in euros from the IMF or some similar arrangement.
Such an approach can cause serious problems. The defaults in Argentina and Russia – in 2001 and 1998 respectively – and the disastrous states of the economies leading up to them, were due to the fixed exchange rate system that these countries chose to pursue. What happens under such a system is that the governments soon find that fluctuations in credit conditions of their domestic economies results in fluctuating demand for their currencies and, since they do not hold sufficient reserves of the currency they have pegged to, their interest rates skyrocket and the government loses its ability to spend as it sees fit. The end result is that they attempt to borrow the foreign currency they need from the IMF. This generally only provides temporary relief and forces the country in question to undertake austerity measures that sends the unemployment rate soaring, increases the deficit through increased unemployment payments and weakens tax revenues as the economy slows. As debt deflation dynamics reinforce themselves, the country runs out of foreign currency reserves and they then default on the promise to convert, which is then typically followed by a depreciation of the currency of about 70%. And so we’re back to square one but with an economy in far worse shape and, potentially, blood in the streets.
As we can see, undertaking a foreign currency peg would put the peripheral countries in exactly the same position as they are currently in; they would remain dependent on holding reserves of a currency that they do not issue. Much better that the exiting country simply allows its currency to float vis-à-vis the euro and let the market set the exchange rate. That way the country will have full sovereign control over their currency and without the threat of default.
Any loans that the government had taken out in euros would either be ignored or, if absolutely necessary, renegotiated in the new currency. Such would be considered a default, but since the entire exit is basically a default, we see no reason why this should be considered problematic. At the same time existing contracts for goods and services taken out by the government in question would also be redenominated in the new currency.
We understand that such a move would lead to the bankruptcies of many within the country. Anyone with private external debt denominated in euros would have to try to service this debt or fall into bankruptcy. While this is unfortunate, it will not interfere with overall levels of employment, output and real domestic consumption. In these circumstances the debtor would still be allowed to keep his existing balance of euros and would not be prevented from trying to accumulate the currency, so he or she would be given every fair chance to service his or her debt.
Any banks that suffered seriously from losses on loans made in euros would probably have to be allowed to fail and their assets be sold on. But such a process is old hat in Europe at this stage. With the ability to issue their own currency the exiting government could facilitate recapitalisations of the banks themselves without need of foreign currencies or having to borrow from abroad.
It is also important that the exiting government discontinues their austerity programs immediately. Since they would no longer depend on the Troika for their funding they should use their newly gained fiscal policy space to accommodate counter-cyclical fiscal adjustments that seek to reduce unemployment and promote economic growth. Argentina after her default in 2001 would be a model in this regard and we would encourage policymakers to consider the direct employment jobs guarantee program (Jefes), an employed labour buffer-stock approach that was initiated there and proved to be far superior to current policies that utilise an unemployed buffer-stock as a price anchor.
Should the newly issued currency weaken substantially, this may be temporarily painful for importers and those reliant on imported goods. However, a weakened currency will also ensure that domestic industry gets a major boost. As exports rise strongly in the new weakened currency, trade partners will begin to seek the currency out in order to buy products with it. This will lead the value of the currency to rise and the added cost pressures that the weakening of the currency placed on imports will fall.
We would also encourage any country that might be facing exit to print up a handy supply of new currency in secret and keep it on hand just in case. With the situation in Europe what it presently is an exit might be a hair-trigger decision and in such circumstances it is better to be prepared than to be forced to take ad hoc actions that could well lead to disaster.